The UK’s Independent Commission on Banking set out to make banking safer and to change both the structure and regulation of banking. It failed to achieve any of these aims.

The UK is still reeling from the great financial crash. Real GDP remains below its 2007 level, the nation’s 8.4% unemployment rate is at a 16-year high, and youth unemployment is over 20% (BBC 2012). Over three million UK citizens can’t find work or have given up looking. Millions more are short on work – working part time or in jobs below, if not far below, their skill levels.

Britain has the world’s largest banking system when measured relative to the size of its economy. UK bank assets exceed GDP by a factor of four. The German and Irish factors are three, whereas the US factor is one (UK Treasury 2011). Hence, the UK was particularly vulnerable to financial crises, let alone what Bank of England Governor, Mervyn King, called “… the most serious financial crisis we’ve seen, at least since the 1930s, if not ever” (Kirkup 2011). Indeed, thanks to the size of its banking sector, the absolute magnitude of Britain’s financial bailout in the recent financial crisis was almost as large as those in the US and the Eurozone (BBC 2008).

To insulate the economy from future financial crises, the Chancellor of the Exchequer established the Independent Commission on Banking, dubbed the Vickers Commission after its chairman, Sir John Vickers.

The Vickers Commission set out to make banking safe, to ensure that what just happened won’t happen again, and to change both the structure and regulation of banking as needed. Unfortunately, the Commission failed in each of these tasks.

Instead of fixing the real problems with banking – opacity and leverage – the Commission’s report rearranges the banks’ deck chairs. Specifically, the Commission proposes ‘ringfencing’ retail banking by separating the ‘good’ bits of banking from the ‘bad’ bits, while leaving all those bits under the same roof.

Good banks, to be owned and operated by bad banks, will only hold good assets (e.g. ‘safe’ mortgages and sovereign bonds), have only good customers (e.g. retail depositors and small and medium sized enterprises), hold a bit more capital, and do only ‘good’ things (i.e. no proprietary trading or transacting in derivatives). The ‘good’ banks will also be closely monitored by the government and be bailed out as needed.

The ‘bad’ banks are the investment banks and other shadow and shadowy financial corporations. Bad banks will have bad customers, namely large corporations, foreigners, and other bad banks. They will hold bad assets such as derivatives, engage in bad practices such as proprietary trading, hold a bit more capital, and have no formal right to government rescue.

Both good and bad banks will hold ‘more’ capital against ‘risky’ assets, submit to stress tests, and make their longer-term debt loss-absorbing to speed up financial funerals (resolutions).

Laurence J. Kotlikoff

Good assets and good banks go bad
One glance at the current Eurozone crisis shows the folly of the commissioners’ way. Good and safe, AAA-rated assets, like Italian government bonds, can suddenly turn bad and risky.

Indeed, today’s safest assets are, according to the market, UK gilts and US treasuries. But based on long-term fiscal gap analysis, they are among the riskiest securities in the world. Yet, the Commission would allow good, ringfenced banks, to borrow £25 for £1 of equity and invest it all in gilts. In this case, the Commission’s ringfenced banks would fail if gilt prices dropped by just 4%.

The fallacious rating and misjudgement of risk is one of the hallmarks of the financial crisis. In the months before they failed both AIG and Lehman Brothers bonds were rated AAA, as were trillions of dollars in top-tranche subprime collateralised debt obligations. Had the Commission’s desired ringfenced banks been in place and purchased these ‘safe’ assets, they would surely have gone under.

Nor would the Commission’s higher capital requirements have saved the day. These requirements are, after all, lower than Lehman’s capital levels at the time it went under. When trust takes a holiday, creditors don’t find much comfort in capital ratios and, for good reason. The banks’ opacity makes it virtually impossible to verify if their capital ratios are actually as high as advertised.

Bad banks are too big to fail
The Commission intimates that the bad banks won’t be saved if they begin to fail. But the fact that it can’t even bring itself to say so in plain English makes clear that this is a prayer, not a realistic implication of their ‘reform’.

Perhaps the Commissioners missed this movie, which opened on 15 September 2008. Lehman Brothers bankruptcy on that day tested the proposition that big bad banks can fail. The test was a colossal disaster. Lehman’s failure set off such a massive run and freezing of the financial system that the US government made clear it would never permit another large financial company to go under. The Bank of England’s intervention in Northern Rock and other UK financial companies provides further proof that bad banks will be saved in the end.

Indeed, in pushing the proposition that bad British banks will be left to sink or swim, the Commission may have dramatically raised the risk of financial collapse in times of financial crisis. The reason is that if the bad banks’ bad customers actually believe the Commission’s intimations that their credits with the bad banks are less likely to be honoured, they will exit stage left at the first sign of trouble. As a result, the instability of the bad banks and the entire financial system will increase.

The other key element of the ‘reform’ is new prudential regulation. This consists of three things: a slightly higher ratio of capital to risk-weighted assets than Basel III mandates, but that remains below the capital ratio Lehman had right before its collapse; an acceptance for ‘bad’ banks of Basel III’s ridiculously high 33-to-1 permissible leverage ratio, which is three times higher than the leverage ratio Lehman reported on 12 September 2008, with the apparent approval of the Securities and Exchange Commission; and the requirement of speedy bank funerals via loss-absorbing debt, whose issuance may be impossible given the uncertainties associated with its payoff.

In sum, the Vickers Report protects neither the good banks nor the bad banks. Nor does it protect the public from the failure of opaque, leveraged banking.

The solution: Limited Purpose Banking
Fortunately, there is a bold, meaningful reform to fix Lombard Street. But it’s one the Commission essentially ignored, notwithstanding its strong endorsement by a very long list of leading policymakers, economists, and financial experts. The reform is called Limited Purpose Banking (LPB). It replaces ‘trust me’ banking with ‘show me’ banking:

LPB bans all limited liability financial companies from marketing anything but mutual funds. Mutual funds, whether open end or closed end, are not allowed to borrow, explicitly or implicitly, and, thus, can never fail.

LPB uses cash mutual funds (replacing retail deposit accounts), which are permitted to hold only cash (currency), for the payment system. Cash mutual funds are backed pound for pound by cash in the vaults and none of this cash is ever lent out.

LPB mandates full and real-time disclosure. It empowers the Financial Services Authority to hire private companies working only for it to verify, appraise, rate and disclose, in real time, all securities held by mutual funds.

LPB requires mutual funds to buy and sell their securities in public auction markets to ensure the public gets the best price for its paper.

LPB’s cash mutual funds would provide a perfectly safe payment system. These cash mutual funds would be the only mutual funds backed to the pound. All other mutual funds, be they closed- or open-end, would fluctuate in price. Since the mutual funds under LPB hold no debt, neither they individually nor the financial system in its entirety can fail. Large private losses could still take place within the financial system, but without endangering the rest of the economy or making claims on taxpayers.

The Vickers Commission’s dereliction of duty
Millions of UK workers and retirees who’ve lost their jobs, life savings, or both can attest to the terrible havoc traditional banking can wreck on peoples’ lives. Yet financial business as usual, albeit with new cosmetics, is the Commission’s answer. Apparently, the UK banks are not only too big to fail. They are also too big to cross.

The Vickers Commission, was charged with keeping the UK economy safe from another major failure of its banking. Unfortunately, it’s done nothing of the kind. Instead, the Commission, whose recommendations the UK government is eagerly adopting, plays lip service to real reform. Worse yet, its proposals may make UK banking riskier than ever.

The Commission’s proposals are a full employment act for regulators and a nightmare in the making for bankers. A banking system that was terribly risky will, on balance, end up riskier, a regulatory system that was dysfunctional will now have many more things to get wrong, and a population that was praying for a sure economic future will be left where the Commission found it – on its knees.

Laurence J Kotlikoff is author of Jimmy Stewart Is Dead and The Economic Consequences of the Vickers Commission, which can be downloaded here.